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Our pal George tells us not to rest on our laurels

Even though George Selgin never said he was a Market Monetarists – he dislikes labels like that – he is awfully close to being a Market Monetarist and many of us are certainly Selginians. So when George speaks we all tend to listen.

Now George is telling us not to rest on our laurels after the Federal Reserve took “a giant leap” after it effectively announced an Evans style policy rule. I have called the Fed’s new rule the Bernanke-Evans rule. There is no doubt that the Market Monetarist bloggers welcomed fed’s latest policy announcement, but George is telling us not be carried away.

Here is George:

In the title of a recent post Scott Sumner jokingly wonders whether, having been credited by the press for badgering Ben Bernanke’s Fed until it at last cried “uncle!” by announcing QE3, he now needs to worry about going down in history as the guy who gave the U.S. its first episode of hyperinflation.

Well, probably not. But if Scott and the rest of the Market Monetarist gang don’t start changing their tune, they may well go down in history as the folks responsible for our next boom-bust cycle.

I’m saying that, not because, like some monetary hawks, I’m dead certain that no substantial part of today’s unemployment is truly cyclical in the crucial sense of being attributable to slack demand. I have my doubts about the matter, to be sure: I think it’s foolish, first of all, to assume that 8.1% must include at least a couple percentage points of cyclical unemployment just because it’s more than that much higher than the postwar average… Still, for for the sake of what I wish to say here, I’m happy to concede that some more QE, aimed at further elevating the level of nominal GDP to restore it to some higher long-run trend value to which the recession itself and overly tight monetary policy have so far prevented it from returning, might do some good.

But although QE3 is in that case something that might do some real good up to a point, it hardly follows that Market Monetarists should treat it as a vindication of their beliefs. On the contrary: if they aim to be truly faithful to those beliefs, they ought to find at least as much to condemn as to praise in the FOMC’s recent policy announcement. And yes, they should be worried–very worried–that if they don’t start condemning the bad parts people will blame them for the consequences. What’s more, they will be justified in doing so.

So what are the bad parts? Two of them in particular stand out. First, the announcement represents a clear move by the Fed toward a more heavy emphasis on employment or “jobs” targeting:

If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.

Yes, there’s that bit about fighting unemployment “in a context of price stability,” and yes, it’s all perfectly in accord with the Fed’s “dual mandate.” But monetarists have long condemned that mandate, and have done so for several good reasons, chief among which is the fact that it may simply be beyond the Fed’s power to achieve what some may regard as “full employment” if the causes of less-than-full employment are structural rather than monetary. The Fed should, according to this view, focus on targeting nominal values only, which can serve as direct indicators of whether money is or is not in short supply. Many old-fashioned monetarists favor a strict inflation target because they view inflation as such an indicator. Market Monetarists are I think quite right in favoring treating the level and growth rate of NGDP as better indicators. But the Fed, in insisting on treating the level of employment as an indicator of whether or not it should cease injecting base money into the economy, departs not only from Market Monetarism but from the broader monetarist lessons that were learned at such great cost during the 1970s. If Market Monetarists don’t start loudly declaring that employment targeting is a really dumb idea, they deserve at very least to get a Cease & Desist letter from counsel representing the estates of Milton Friedman and Anna Schwartz telling them, politely but nonetheless menacingly, that they had better quit infringing the Monetarist trademark.

So what is George saying? Well, it is really quite obvious. Monetary policy should focus on nominal targets – such a price level target or a NGDP level target – rather than on real target like an unemployment target (as the fed now is doing). This is George’s position and it is also the position of traditional monetarists and more important it has always been the position of Market Monetarists like Sumner, Beckworth and myself.

So just to make it completely clear….

…It is STUPID to target real variables such as the unemployment rate

There is no doubt of my position in that regard and that is also why I and other Market Monetarists are advocating NGDP level targeting. The central bank is fully in control the level of NGDP, but never real GDP or the level of unemployment.

With sticky prices and wages the central bank can likely reduce unemployment in the short run, but in the medium term the Phillips curve certainly is vertical and as a result monetary policy cannot permanently reduce the level of unemployment – supply side problems cannot be solved with demand side measures. That is very simple.

As a consequence I am also tremendously skeptical about the Federal Reserve’s so-called dual mandate. To quote myself:

” …I don’t think the Fed’s mandate is meaningful. The Fed should not try to maximize employment. In the long run employment is determined by factors completely outside of the Fed’s control. In the long run unemployment is determined by supply factors. In my view the only task of the Fed should be to ensure nominal stability and monetary neutrality (not distort relative prices) and the best way to do that is through a NGDP level target.”

Is the glass half empty or half full?

It is clear that it has never been a Market Monetarists position to advocate that the Fed or any other central bank should target labour market conditions, but this is really a question about whether the glass is half full or half empty. George is arguing that the glass is half empty, while his Market Monetarist pals argue it is half full.

The reasons why the Market Monetarists are arguing the glass is half full are the following:

1) The fed has become much more clear on what it wants to achieve with its monetary policy actions – we nearly got a rule. One can debate the rule, but it is certainly better than nothing and it will do a lot to stabilise and guide market expectations going forward. That will also make fed policy much less discretionary. Victory number one for the Market Monetarists!

2) The fed has become much more clear on its monetary policy instrument – it is a about increasing (or decreasing) the money base by buying Mortgage Backed Securities (MBS). To Market Monetarists it is not really important what you buy to increase the money base – the point is the monetary policy is conducted though changes in the money base rather than through changes in interest rates. This I think is another major monetarist victory!

3) The fed’s policy actions will be open-ended – the focus will no long be on how much QE the fed will do, but on what it will do and the fed will – if it follows through on its promises – do whatever it takes to fulfill its policy target. Victory number three!

It is certainly not perfect, but it certainly is a major change compared to how the fed has conducted monetary policy over the past four years. We can of course not know whether the fed will change direction tomorrow or in a month or in a year, but we are certainly heading in the right direction. I am sure that George would agree that these three points are steps in the right direction.

But lets get to the “half empty” part – the fed’s new unemployment target. George certainly worries about it as do I and other Market Monetarists. Bill Woolsey makes this point very clear in a recent blog post. However, I think there is an empirical difference in how George see the US economy and how most Market Monetarists see it. In George’s view it is not given that the present level of unemployment in the US primarily is a result of demand side factors. On the other hand while most Market Monetarists acknowledge that part of the rise in US unemployment is due to supply side factors such as higher minimum wages we also strongly believe that the rise in unemployment has been caused by a contraction in aggregate demand. As a consequence we are less worried that the fed’s new unemployment target will cause problems in the short to medium term in the US.

In that regard it should be noted that the so-called Evans rule mean that the fed will ease monetary policy until US unemployment drops below 7% or PCE core inflation increases above 3%. Fundamentally I think that is quite a conservative policy. In fact one could even argue that that will not be nearly enough to bring NGDP back to a level which in anyway is comparable to the pre-crisis trend.

We should listen to our pal George and continue advocacy of NGDP level targeting

The fact that I personally is not overly worried about a conservative Evans rule (7%/3%) will lead to a new boom-bust as George seem to suggest does, however, not mean that we should stop our advocacy. While we seem to have won first round we should make sure to win the next round as well.

It is therefore obvious that we should continue to strongly advocate NGDP level targeting and we should certainly also warn against the potential dangers of unemployment targeting.

Finally I would also argue that Market Monetarists should step up our campaign against moral hazard. There is no doubt the failed monetary policies over the past four years have led to an unprecedented increase in explicit and implicit government guarantees to banks and other nations. These guarantees obviously should be scaled back as fast as possible. A rule based monetary policy is the best policy to avoid that the scaling back of such too-big-to-fail procedures will lead to unwarranted financial distress. This should do a lot to ease George’s fears of another boom-bust episode playing out as the US and the global economy start to recover. (See also my earlier post on moral hazard and the risk of boom-bust here.)

Similarly if we are so lucky that the fed’s new policy set-up will be start of the end of the slump then Market Monetarists should be as eager to fight excessive monetary easing as we have been in fighting overly tight monetary policy. In that regard I would argue that I personally have a pretty solid track record as I was extremely critical about what I saw as overly easy monetary policy in the years just prior to the crisis hit in 2007-8 in countries like Iceland and the Central and Eastern European countries.

So George, there is no reason to worry – we don’t trust the fed more than you do…

PS I stole (paraphrased) my headline from one of George’s Facebook updates.

Update: Scott Sumner also comments on George’s post and George has a reply.

7 Comments

Lars, I think George is right to worry. The “program” moves in the right direction, but the character of the “move” is maybe “ominous” for its future. The chosen “level” (unspecified) target is bad. The IT target is maintained, although people think the implication is that there could be some temporary flexibilty, etc.
As you know, I wasn´t happy to start with and am even less so now because MM has been (wrongly) associated with the program and the chances that it´ll derail are not insignificant.

I don’t know what a sort of “in between” policy should look like. Scott Sumner had a few recommendations, and the Fed took at least one of those which was open-ended easing with something to tie it to economic outcomes instead of saying something like we’re putting in X billions of dollars to X date and then… who knows. From a moral perspective I don’t believe that continuation of doing nothing would have been preferable to doing some portion of it wrong. I agree with George in the respect that we need to be sure that MM isn’t associated with Bernanke’s bungling; and in that sense I think it’s great that Woodford is not giving Dr. Sumner credit where credit is due.

Benjamin Cole

I think there may be less to worry about than meets the eye, and the worry is that we are not stimulating enough.

The USA economy has been inoculated against inflation since the 1970s, and even then we did not have hyperinflation, but only low double-digit inflation. Since then, private sector unions have been all but crushed, and trade is now 30 percent of GDP not under 10 percent, and the retail environment is much more competitive.

Moreover, the 1970s cost-push inflation was accommodated by an expansive monetary policy. And still we only got lower double-digit inflation.

No one I know has pricing power today.

The Fed should be far more aggressive in seeking growth.

Selgin is a nice guy, and smart, but the current-day phobia about inflation, even microscopic rates of it, seems misplaced. How about we try some prosperity first, and then worry about inflation.